Oil: The Long Game

At its semi-annual meeting in late November, OPEC resolved to continue supplying some 30 million barrels per day into the world oil market. As a result, the price of oil continued to fall in December with Brent Crude finishing 2014 at US$57 a barrel – almost half its opening level. The price has continued to weaken so far in the new year and is back to levels last seen in 2009.

Such corrections in the oil price are not unprecedented. However, on this occasion it is the circumstances surrounding it that are unusual. The problem lies in a mismatch between demand and supply of some 2 million barrels per day; the largest since 1998, when crude prices fell by 30%. Usually such corrections occur during deep global recessions, when demand falls with activity levels. However, we are far from being in a global recession. Demand for oil is currently growing, albeit relatively unspectacularly, at some 1%, (or 900 barrels per day), per annum.

What has changed is the supply situation. US shale oil has resulted in a new source of ‘cheap’ oil, which now supplies some 9 million barrels per day and was projected to grow by a further 1 million barrels per day in 2015. As a result, during 2014, the global oil market reached a tipping point, when supply began to comfortably exceed demand. Hence, the current market problem is essentially one of excess supply.

During the previous 10 years, OPEC, led by Saudi Arabia, has acted as the swing producer in the market, managing the oil price, which in more recent times has traded in a US$90-$125 barrel range, which suited all of the main interested parties. However, conscious of OPEC’s now waning market share (down from half to a third in 20 years) and the proliferating growth of non-OPEC oil (more than enough to meet projected demand increases on its own) Saudi Arabia has now decided to cease managing the market, partly because it no longer can but also with an eye on the more strategic long-term objective of maintaining OPEC’s market share and hence its economic and political influence.

The most obvious way to balance the market is to reduce the overhang of supply and allow demand to eventually catch up with capacity. Hence, it has started a price war with the only other supplier that has the capacity to meaningfully reduce output – US shale. The result so far has been a halving of the price to a level that is painful for not only both parties but also other market participants, such as Russia, Nigeria and Venezuela.

The Gulf states, which are the lowest cost producers and account for over half of OPEC’s output, instigated the no change in supply agreement in November and have so far ignored calls from its more peripheral ( and vulnerable) members for a meeting before the next one, scheduled for 5 June. This prospect is not seen to be likely without a wider (than OPEC) agreement to cut output. At the moment, such an initiative does not look likely.

A sustained oil price below US$55 a barrel is seen to leave around half of US shale oil production loss making, triggering the risk of eventual bankruptcy. However, in the short term, the upfront nature of the costs of drilling, followed by low subsequent marginal costs and the fact that many operators have sold forward output at more economic prices, suggests that, on a three-to-six month view, any reduction in output is likely to be limited. However, beyond this timescale there is growing evidence (via rig counts, well permits, cap ex budgets etc) that previous expansion plans are now being reined in. Hence, US shale output is now expected to grow by 750 barrels per day, rather than 1 million barrels per day.

Therefore, in the absence of an unforeseen event, such as an increase in geopolitical tension, materially reducing supply, over the first half of the year at least, the oil price looks set to languish.

The OPEC meeting in June is the first meaningful opportunity to crimp supply. Hopes centre on a 1.5 million barrels per day reduction in output, in order to bring OPEC demand and supply into line. However, the decision is more a political one and so, by its very nature, difficult to predict.

An analysis of past oil market corrections suggests that a price of around US$58 barrel is currently required in order to trigger the sort of market upheaval needed to prompt an adjustment in supply. Hence, we are now at a level that makes it painful enough to encourage participants to act. The prospect of strengthening demand suggests that a modest squeeze in supply would be enough to propel the price back to the US$80-90 barrel level needed to restore industry profitability.

The wider implications of a low oil price should also not be ignored. Saudi Arabia is probably also looking to re-establish its importance to the US by humbling Russia and Iran. In addition, the potential reaction of Russia to its largely oil based economic problems and/ or the possibility of renewed turmoil in the Middle East, could trigger the sort of geopolitical event that would be the market’s salvation.

Markets don’t go down forever. Oil is now cheap on just about every metric. The recent rise in tanker charter rates is believed to reflect Chinese initiatives to take advantage of the price weakness and add to its strategic reserves. The market itself is also beginning to reflect the value available. Futures prices have moved into deep contango (ie the spot price is well below the price for delivery in the future) making it possible to buy now and sell forward at a guaranteed profit over and above the interim holding costs. This suggests that any further weakness in the market is likely to be limited.

The oil market’s current predicament is one typical of the boom-bust cycle that most commodities experience on a periodic basis. Oil at US$100 per barrel prompted the shale boom, which in turn sowed the seeds of the current production glut. We will now find out how shale reacts to a price at or below US$80 barrels a day. A short-term surplus will inevitably become a medium-term deficit as capital spending is reined in, triggering the cycle all over again. To move on, one side or the other needs to cut production. As we have seen this is unlikely in the first half of the year. Beyond then, it’s a matter of who can stand the pain the longest. This could run for some time.

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